Bernadette Lewis: Maximising pension contributions for shareholding directors

Bernadette Lewis looks at the interaction between salary, dividends and employer pension contributions in her latest technical article for Retirement Planner

Shareholding director’s remuneration strategies 

Owners of small private limited companies can control the type of remuneration they receive. The traditional mix of low salary plus dividends survives, despite the 2016/17 changes.

These saw the removal of the 10% dividend tax credit, the introduction of a 0% dividend allowance using up part of the income tax band(s) it sits within, and effectively increased rates of dividend tax – 7.5%, 32.5% and 38.1% for dividend income sitting in the basic, higher and additional rate bands respectively. 

By now, owner-directors of limited companies will have adapted to these changes. But for 2018/19, they also have to take account of the reduction in the dividend allowance from £5,000 to £2,000.  

Taking remuneration as dividends rather than salary still provides tax advantages for most, despite the reduction in the dividend allowance. But including employer pension contributions in the mix can maximise tax efficiency.

A client’s accountant can confirm the level of dividends available along with how much salary they need to secure state pension and other contributory benefits, and maximum pension funding taking account of their annual allowance plus any carry forward.

Salary and dividends 

Many directors use a strategy of paying themselves enough salary to secure contributory state benefits including the state pension without incurring any National Insurance (NI) contributions, and the balance in dividends.

Example 

Shani is 45-years-old, runs her own limited company and remunerates herself using salary and dividends.  

After a discussion with her accountant, she considers paying herself a salary of £8,424, in line with the NI primary threshold. This level of earnings secures a qualifying NI year for contributory benefits, including the new state pension, without incurring employer or employee NI.  

Shani’s accountant also confirms that she’s had a particularly good year and after paying that level of salary, has £50,000 distributable profits before deducting 19% corporation tax. So after paying corporation tax, she could pay herself a dividend of £40,500. 

Salary 

Salary within £11,850 personal allowance 

 

£8,424 

£8,424.00 
Dividend 

Dividend within personal allowance 

Dividend [email protected] 0% 

Dividend @ basic rate 7.5% 

Dividend @ higher rate 32.5% 

 

£3,426 

£2,000 

£32,500 

£2,574 

£40,500.00 

 

 

(£2,437.50) 

(£836.55) 

Gross remuneration 

Total tax 

Net remuneration 

  £48,924.00 

(£3,274.05) 

£45,649.95 

 

Extraction rate 

That is, the amount received by the shareholder director as a percentage of the total cost to the company:  

Amount received after all taxes  = 

Cost to the company 

£48,924 – £3,274.05  =  

£8,424 + £50,000 

78.14% 

 

Salary, dividend and employer pension contribution 

However, Shani also speaks to her financial adviser. This further discussion alerts her to the option of swapping some of her dividend remuneration for an employer pension contribution. The adviser points out her need to fund her own retirement and that her unusually profitable year offers a good opportunity to contribute a significant lump sum towards this. As an added advantage, she can also improve her overall tax position.  

Example 

One option is for Shani to swap part of her dividend for a £20,000 employer pension contribution. This will use up part of the full £40,000 annual allowance she’s got available in 2018/19. While she has unused annual allowance, this level of contribution ensures her reduced take home income still leaves her with enough to comfortably meet her outgoings for 2018/19.  

Shani decides to keep her salary at £8,424. She pays herself a reduced dividend of £24,300 funded out of £30,000 before tax profits. And benefits from a £20,000 employer pension contribution, reducing the taxable profits by the same amount. 

 Shani expects to be a basic rate taxpayer in retirement, so the following calculation accounts for the potential future tax on her pension contribution on this basis.  

Salary 

Salary within £11,850 personal allowance 

 

£8,424 

£8,424.00 
Dividend 

Dividend within personal allowance Dividend [email protected] 0% 

Dividend @ basic rate 7.5% 

 

£3,426 

£2,000 

£18,874 

£24,300.00 

 

 

(£1,415.55) 

Employer pension contribution 

Assumed tax treatment: 

Tax-free cash  

Pension income @ 20% 

 

 

£5,000 

£15,000 

£20,000.00 

 

 

(£3,000.00) 

Gross remuneration 

Total tax 

Net effective remuneration 

  £52,724.00 

(£4,415.55) 

£48,308.45 

 

Extraction rate 

Amount received after all taxes  = 

Cost to the company 

£52,724 – £4,415.55         = 

£8,424 + £30,000 + £20,000 

82.69% 

 

Shani has some great incentives to consider the most tax-efficient way to remunerate herself.

As she operates through her own limited company, she needs to consider the best way to fund her own retirement provision over and above her state pension entitlement. Switching some of the dividends to an employer pension contribution can also save her tax in 2018/19.  

Her low salary isn’t a barrier to this planning. Unlike the rules for benefitting from tax relief on member contributions, there’s no need to have salary of a certain level to receive employer pension contributions. As Shani’s the driving force generating her company’s profits there should be no issue with treating the employer contribution as a deductible business expense, incurred wholly and exclusively for the purposes of trade.  

Two heads

Many director shareholders can improve their overall tax position by checking with both their financial adviser – to ensure pension contributions aren’t overlooked – and their accountant to ensure they’re receiving the right mix of salary, dividends and pension contributions.

Even if it’s not always practical to fully maximise employer contributions within the annual allowance including carry forward, the exercise can still improve profit extraction. And that’s in addition to the usual retirement planning benefits.  

Bernadette Lewis is financial planning manager at Scottish Widows